Martin Ferguson, director and portfolio manager at Mawer Investment Management Ltd., says that investors in the Canadian equity market have been favouring high-risk, highly leveraged smaller companies for some time.
"It has been the opposite of a flight to safety," says Ferguson, who manages more than $1 billion in small-cap mandates at Calgary-based Mawer. This trend shows up clearly, he says, in the total returns for both 2009 and the first quarter of 2010, if you look at leading Canadian indexes that run the market-cap spectrum.
For instance, the S&P/TSX 60 Index, "which contains the largest and theoretically the least risky securities, was the worst performing index," Ferguson notes. It has "even underperformed" the S&P/TSX Composite Index, which includes mid-cap stocks.
The S&P/TSX Composite has, in turn, substantially underperformed the indexes that focus on small-caps, he notes. This includes the widely followed small-cap benchmark, the BMO Blended Weighted Small Cap Index.
Ferguson points out that the index that performed best in both 2009 and in the first quarter of 2010 was the BMO Blended Unweighted Small Cap Index. This index, which contains the same companies as its weighted counterpart, equally weights the companies. As a result, it has "the smallest average market capitalization and the riskiest, most volatile profile of all four indexes compared."
Ferguson underscores that he has "not participated in the rush to higher-risk smaller small-caps." Instead, he has stuck to his well honed discipline that targets "high-quality" wealth-creating companies that trade at a discount to their intrinsic value, as calculated using discounted-cash-flow analysis.
| Small-cap indexes outperform | |||||
| Index | 2009 | Q1 2010 | |||
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| S&P/TSX 60 | 31.9% | 2.6% | |||
| S&P/TSX Composite | 35.1% | 3.1% | |||
| BMO Small Cap Blended Weighted | 75.1% | 7.4% | |||
| BMO Small Cap Blended Unweighted | 93.2% | 8.5% | |||
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| Source: Morningstar | |||||
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"The companies must generate a sufficient return on capital to compensate for the risks they take on." They must also be resilient in downturns, he says, "due to their strong business models and competitive advantages."
At Mawer, Ferguson's mandates includeMawer New Canada 
, which is closed to new investors, andBMO Guardian Enterprise , which is managed along similar lines.
Ferguson targets companies that have a market capitalization of $500 million or less at the time of first purchase. The "diversified" portfolio has 54 names with a median market capitalization of $368 million. He is fully invested at all times.
Of late, Ferguson says that he has been "high-grading" his portfolio by selling off some of the holdings and investing the proceeds in names that offer "better prospects and better relative value."
A new name in the materials sector is a leading North American producer and marketer of industrial pressure-treated wood products, Stella-Jones Inc. SJ, which currently constitutes 2% of the portfolio. The company, which has a market capitalization of $437 million, specializes in the production of railway ties as well as wood poles for electrical utilities and telecommunications companies.
"It has a dominant market share in Canada with 70% of the ties and utilities business and is the number-two player in the United States." Some 90% of its orders represent replacement demand, he says, which makes for good cash-flow predictability.
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Led by CEO Brian McManus, Stella-Jones is a consolidator in this business, says Ferguson, and has been growing the company via strategic acquisitions. The company generates a return on equity of close to 20%. The stock trades at 10 times 2010 earnings- per-share estimates and nine times EPS estimates for 2011.
An industrial company "that dominates its niche -- the manufacture of heavy-duty transit buses in Canada and the United States" -- is New Flyer Industries Inc. NFI.UN, which has a market capitalization of $525 million.
New Flyer Industries, which has been in the portfolio for two years, currently represents a 4.4% weighting and is among Ferguson's top 10 holdings. "There are high barriers to entry in its business," he says.
The company has a broad product line and solid business relationships with the majority of the main transit authorities on both sides of the border. It has a "unique financial structure" from an investor's standpoint, says Ferguson.
The company "generates a large amount of free cash flow." It pays out an annual distribution (interest plus dividend) of $1.17 per unit and has a yield of 10.9%. The valuation on the business -- enterprise value (equity plus debt) at six times EBITDA (earnings before interest, depreciation and amortization) -- is "inexpensive," Ferguson says.
A consumer-staples company that "also dominates its niche" is Alliance Grain Traders Inc. AGT, which has a market capitalization of $600 million and constitutes some 2% of Ferguson's portfolio.
Alliance Grain is a major pulse (lentils, peas, chick peas and bean) processor and exporter globally. It has processing facilities in some of the best pulse-growing regions in Canada, the United States, Turkey and Australia.
It provides value-added processing (cleaning, splitting, sorting and bagging) of pulses and "earns a steady and high margin on this," says Ferguson. Alliance Grain's return on equity is almost 20%. The stock trades at around 10 times forward EPS estimates.
Ferguson's recent sales from his portfolio include Ritchie Bros. Auctioneers Inc. RBA, which he had held for "more than a decade." The stock has done well, he says, and has moved into larger-cap territory. "While I like its business model, there were other stocks that I considered offered more attractive upside."
Also divested by Ferguson was his holding in Supremex Income Fund SXP.UN, a manufacturer and marketer of a broad range of stationery and custom envelopes. "The industry fundamentals are very challenging," he says. "Supremex's revenue and potentially its margins may suffer as a result."
